On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank"), one of the most wide-ranging legislative efforts at financial reform since the Great Depression. While much of the Act focuses on significant financial regulatory measures, it also contains a number of procedural and substantive provisions that impact securities litigation and enforcement. The changes in the law give the Securities and Exchange Commission, as well as injured private parties, additional tools for enforcing the securities laws and seeking remedies. Below is a summary of the key changes.
Requisite State Of Mind Lowered For Aiding And Abetting Violations In SEC Actions
Prior to the enactment of Dodd-Frank, the Securities and Exchange Commission was required to show that an individual charged with aiding and abetting under the Securities Act of 1933 ("Securities Act"), the Securities Exchange Act of 1934 ("Exchange Act"), the Investment Company Act of 1940 ("Investment Company Act"), and the Investment Advisers Act of 1940 ("Investment Advisers Act") "knowingly" provided substantial assistance to another person in violation of the securities laws. Sections 929M-O of Dodd-Frank lower the requisite state of mind to include "recklessly" providing substantial assistance. Importantly, calls from some lawmakers to reverse the Supreme Court's decision in Central Bank of Denver, NA. v. First Interstate Bank of Denver, N.A. , 511 U.S. 164 (1994) and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. , 552 U.S. 148 (2008), and to create a private cause of action for aiding and abetting violations of the securities laws were rejected. However, Section 929Z(a) provides that the "Comptroller General of the United States shall conduct a study on the impact of authorizing a private right of action against any person who aids or abets another person in violation of the securities laws."
Expanded Protection And New Incentives For Whistleblowers
To encourage whistleblowers, Section 922(a) creates new incentives and additional protections for individual whistleblowers providing "original information" voluntarily supplied in SEC or Commodity Futures Trading Commission enforcement actions resulting in sanctions greater than $1,000,000. Under Dodd-Frank, these whistleblowers are entitled to recover 10 to 30 percent of the monetary sanctions (with the determination of the amount of the award entrusted to the discretion of the Commission), to be paid from a newly established SEC Investor Protection Fund funded by monetary sanctions collected by the SEC. Section 922(a) also provides a private right of action for whistleblowers against retaliating employers, with a six-year statute of limitations (and potentially up to ten years) and allows for the subpoenaing of witnesses for trial or hearing anywhere in the United States. Whistleblowers can bring their claims in federal court seeking reinstatement, double back pay, with interest, and compensation for litigation costs and attorneys' fees. Notably, this provision is different from Section 806 of the Sarbanes-Oxley Act of 2002, which provides for an award of reinstatement and back pay, but not double back pay, and requires the whistleblower to file a complaint with the secretary of labor before the filing of a federal court action.
SEC May Impose Monetary Penalties In Cease And Desist Proceedings
Section 929P(a) of Dodd-Frank expands the SEC's enforcement tools by granting it authority to impose civil penalties in cease and desist proceedings under the Securities Act, the Exchange Act, the Investment Company Act, and the Investment Advisers Act, even against those individuals not regulated by the SEC. Consequently, with this additional tool, the SEC may elect to avoid federal court and instead choose to bring more actions as administrative proceedings. The potential benefits to the SEC of proceeding administratively include limited discovery, the lack of a jury trial, and, on appeal, a de novo standard of review by the SEC commissioners who approved the original filing of the complaint.
New Clawback Of Executive Incentive-Based Compensation
Dodd-Frank Section 954 requires that an issuer develop and implement a policy for (i) the disclosure of incentive-based compensation "that is based on financial information required to be reported under the securities laws," and (ii) the recovery of incentive-based compensation from current and former executive officers in the event of an accounting restatement due to material noncompliance of the issuer with any financial reporting requirement under the securities laws. Section 954 is independent of Section 304 of the Sarbanes-Oxley Act ("SOX"), which provides for a clawback of the incentive compensation of a chief executive officer or chief financial officer after an accounting restatement due to the material noncompliance of the issuer as a result of misconduct. While SOX 304 applies only to the issuer's CEO and CFO, the Dodd-Frank clawback affects all current and former executive officers and applies to incentive-based compensation during the three years preceding the misstated financial filing, rather than the one-year term specified under SOX. Importantly, Dodd-Frank specifically provides that the issuer can recover only incentive compensation that was "in excess of what would have been paid to the executive officer under the accounting restatement." Another significant difference between SOX 304 and Section 954 of Dodd-Frank is that "misconduct" is required under SOX, but under Dodd-Frank the standard is "material noncompliance . . . with any financial reporting requirement under the securities laws." Finally, Dodd-Frank provides that issuers who do not comply with the requirements of the section cannot be listed on national securities exchanges and national securities associations.
Expansion Of Federal Jurisdiction To Activities Outside The United States In Cases Brought By The Government
On June 24, 2010, the Supreme Court ruled in Morrison v. National Australia Bank Ltd. , 561 U.S. ___, slip op. No. 08-1191 (June 24, 2010), that the antifraud provisions of the U.S. securities laws do not apply to foreign plaintiffs suing foreign defendants for fraud in connection with securities transactions on foreign exchanges. A day later, Dodd-Frank was passed out of conference committee reversing Morrison in part and confirming Congress's intent that in proceedings brought by the SEC or the United States government the securities laws will have extraterritorial effect. Section 929P(b) of Dodd-Frank amends the Securities Act, the Exchange Act, and the Investment Advisers Act to allow the SEC or the United States to bring enforcement actions in instances where (i) there is "conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States" or (ii) the "conduct occurring outside the United States that has a foreseeable substantial effect within the United States." Thus, for purposes of actions brought by the SEC or the Department of Justice, Dodd-Frank effectively restores the "conduct and effects" test, which examines where a supposed fraud was perpetrated and where the effects of such fraud would be felt. Importantly, Section 929(b) has no effect on Morrison with respect to private actions, although a provision of the Act requires an SEC study of applying the above test to private actions.
Credit Rating Agencies Face Increased Exposure
Pursuant to Section 933, Section 15E of the Exchange Act is amended such that enforcement and penalty provisions apply to credit rating agency statements "in the same manner and to the same extent as such provisions apply to statements made by a registered public accounting firm or a securities analyst under the securities laws, and such statements shall not be deemed forward-looking statements for the purposes of [the PSLRA safe harbor]." Additionally, in a private action under Section 15E, the plaintiff must plead with particularity only that the credit rating agency knowingly or recklessly failed (i) "to conduct a reasonable investigation of the rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk" or (ii) "to obtain reasonable verification of such factual elements . . . from other sources that the credit rating agency considered to be competent and that were independent of the issuer and underwriter."
SEC Empowered To Ban Or Limit Use Of Mandatory Arbitration Provisions
Section 921 of Dodd-Frank amends the Exchange Act and the Investment Advisers Act to provide the SEC with rulemaking authority to ban or limit the extent to which brokers, dealers, municipal securities dealers and investment advisers can require customers or clients to submit to arbitration future disputes arising under the federal securities laws.
Deadline Established For Completing Enforcement Investigations And Compliance Examinations And Inspections
Section 929U(a) of Dodd-Frank specifies that within 180 days of providing a Wells notification to any person, "the Commission staff shall" either bring an action against that person or provide written notice to the director of the Division of Enforcement of its intent not to do so. If the director of the Enforcement Division (or the director's designee) determines the enforcement investigation is "sufficiently complex," such that making a determination regarding filing such an action cannot be completed within the 180-day period, then the director may extend the deadline for an additional 180-day period, contingent only upon providing notice to the Commission chairperson. Further extensions may be obtained with approval from the Commission. It is uncertain how this provision will work in practice, given certain definitional uncertainties: It is the commissioners, not the staff, who make the ultimate determination whether to authorize an action. It is the Commission, not the staff, that files any such action. And the director of the Division of Enforcement is a member of the staff.
Section 929U(b) provides that the SEC will have 180 days after completing an onsite compliance examination or inspection, or receiving all requested records, to inform the entity being examined or inspected that the examination or inspection has concluded, has concluded without findings, or that the staff requests that the entity undertake corrective action. Here, too, extension of the deadline is available, in this case where the examination or inspection is "sufficiently complex" and the head of the division or office within the Commission conducting the examination or inspection provides notice to the chairperson of the Commission.
Control Person Liability Under Exchange Act Expanded
Section 929P(c) expands Section 20(a) of the Securities Exchange Act such that control person liability applies to SEC enforcement actions, in addition to private actions.
Short Sale Reforms
Dodd-Frank Section 929X prohibits the manipulative short sale of any security and requires that the SEC promulgate rules regarding certain public disclosures concerning short sale activity and investor notifications relating to securities lending practices.
David S. Frankel, Partner, has focused on the defense of white collar criminal prosecutions, SEC, CFTC, and FINRA enforcement actions and arbitrations and other administrative proceedings for over 25 years. Alan R. Friedman, Partner, focuses on litigation and defense of complex civil and criminal cases. Melissa J. Prober, Associate, has a practice in commercial litigation, with an emphasis on employment law, securities and white collar criminal defense.